Draft financial regulatory reform legislation released this week1 by Sen. Christopher J. Dodd (D-Conn.), chairman of the U.S. Senate Committee on Banking, Housing and Urban Affairs, would, like the financial regulatory reform bill passed by the House of Representatives on December 11, 2009,2 mandate retention of economic risk by securitizers, provide for increased disclosure in connection with offerings of asset-backed securities (“ABS”), and permit the Securities and Exchange Commission (the “SEC”) to expand periodic reporting requirements for SEC-registered offerings of ABS. The draft legislation also proposes to reform the credit ratings process.
This draft of the Restoring American Financial Stability Act of 2010 (the “Act”), which is based on an earlier version circulated before the passage of the House bill, appears to represent Sen. Dodd’s effort to jumpstart the stalled financial regulatory reform process by not only including provisions supported by Democrats, but also including some compromises reached through discussions with Republicans in an effort to garner broader support.
The provisions of the Act dealing specifically with ABS are a relatively small part of more than 1,300 pages of law that would address systemic risk in the U.S. financial system by creating a new oversight scheme for systemically important financial institutions and various types of financial transactions.3
Retention of Risk
The Act would require most “securitizers”4 to “retain an economic interest in a material portion of the credit risk for any asset that the securitizer, through the issuance of an asset-backed security, transfers, sells or conveys to a third party.” In general, the minimum credit risk retention would be five percent (reduced from 10 percent in the previous draft Senate bill and now consistent with the five percent minimum risk retention proposed in the House bill) and the risk could not be hedged, directly or indirectly. But the revised draft bill provides that the risk retention requirement for any particular asset could be less than five percent if the originator of the asset were to meet underwriting standards to be specified in implementing regulations to be issued jointly by the SEC, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (the “Regulators”). Unlike the House bill, the Act would not require risk retention above five percent if credit underwriting or due diligence is insufficient. These provisions of the Act would address risk retention only by securitizers, not in connection with whole loan transfers.
The implementing regulations would be required to establish separate rules for securitizers of different classes of assets, including residential mortgage loans, commercial mortgage loans, auto loans and any other class of assets that may be specified by the Regulators. For each asset class, the rules would include underwriting standards which “specify the terms, conditions, and characteristics of a loan within the asset class that indicate a reduced credit risk with respect to the loan.” Loans that meet these standards would be exempted in whole or in part from the five percent retention requirement.
Where the securitizer is different from the “originator”5 of the securitized assets (e.g., in transactions by shelf aggregators), the revised draft of the Act clarifies that the implementing regulations are to provide for an allocation of the risk retention obligations between the securitizer and the originator, and that risk retention by the originator will correspondingly reduce the risk retention requirement for the securitizer. In determining the allocation of risk retention between the securitizer and the originator, the Regulators would be required to consider (1) whether a class of assets has “terms, conditions, and characteristics that reflect reduced credit risk,” (2) “whether the form or volume of transactions in securitization markets” might create incentives for the class of assets to be originated imprudently, and (3) the potential impact of the risk retention obligations on access to credit on reasonable terms by consumers and businesses. Additionally, the Regulators may jointly issue exemptions, exceptions or adjustments to the requirements of the revised draft bill, including the risk retention requirements and the risk hedging prohibition.
The risk retention requirements would apply to securitizers of “asset-backed securities,” which is defined more broadly than under Regulation AB.6 Under the Act, an “asset-backed security” would be “a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including
(i) a collateralized mortgage obligation;
(ii) a collateralized debt obligation;
(iii) a collateralized bond obligation;
(iv) a collateralized debt obligation of asset-backed securities;
(v) a collateralized debt obligation of collateralized debt obligations; and
(vi) a security that the [SEC], by rule, determines to be an asset-backed security.”
An “asset-backed security” would not include “a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.”
A “securitizer” is either “an issuer of an asset-backed security” or “a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer.” An “originator” is “any person who sells assets to a securitizer.”
The implementing regulations also would provide for permissible forms of risk retention and the minimum duration of the risk retention.
The implementing regulations for the Act’s risk retention requirements would be required to be promulgated no later than 270 days after enactment of the Act. They would be effective for securitizers and originators of asset-backed securities backed by residential mortgage loans one year after the date that final rules are published in the Federal Register. The effective date for implementing regulations with respect to other classes of asset-backed securities would be two years after that publication. Because the final rules presumably will be preceded by proposed rules and one or more comment periods, the effectiveness of these requirements is likely to be substantially delayed.
Under the Act, the SEC would be directed to adopt regulations requiring every issuer of asset-backed securities that offers ABS in an SEC-registered offering “to perform a due diligence analysis” of the securitized assets, and to disclose “the nature of the analysis.”
The Act would require that “the issuer or underwriter of any asset-backed security. . .make publicly available any third-party due diligence report” that is obtained by the issuer or underwriter.
The Act would amend the Securities Act of 1933 to require the SEC to adopt regulations requiring each ABS issuer to disclose, for each tranche or class of ABS, information about the pool assets, including, at a minimum, “asset-level or loan-level data necessary for investors to independently perform due diligence.” This requirement would apply to all asset classes. The required information would include “unique identifiers relating to loan brokers or originators,” “the nature and extent of the compensation of the broker or originator” of the pool assets, and the amount of risk retention by the originator or securitizer. The SEC would be required to establish standards for the format of such disclosures in order to facilitate comparison of pool information with respect to various ABS of the same or similar asset classes.
Like the House bill, the Act would require the SEC to adopt regulations requiring rating agencies to include in their rating reports for ABS a description of both (1) the representations, warranties and enforcement mechanisms available to investors and (2) how those features differ from representations, warranties and enforcement mechanisms that are available to holders of similar ABS. Securitizers would be required to disclose “fulfilled and unfulfilled repurchase requests across all trusts aggregated by the securitizer” in order to permit investors to identify originators that exhibit “clear underwriting deficiencies.” How this disclosure would be made is not clear.
As with the House bill, the Act would amend the Securities Exchange Act of 1934 (the “Exchange Act”) to eliminate the ability of most SEC-registered securitizations to cease filing periodic reports after the trust’s first fiscal year,7 and would give the SEC authority to determine when the reporting obligation for various types of ABS may be terminated.
Regulation of Rating Agencies
The provisions of the Act that would apply to rating agencies are very similar to those contained in the earlier draft Senate bill. The Act would vest the SEC with broad authority to regulate the manner in which rating agencies operate. Each nationally recognized statistical rating organization (an “NRSRO”) would be required to submit an annual report on its internal controls governing rating procedures and would be subject to annual examination by a newly established Office of Credit Ratings within the SEC. Each such examination would be followed by publication of an inspection report, available to the public, summarizing the results. The SEC would be charged with promulgating regulations governing the adoption, modification and disclosure of rating methodologies, and would have the power to suspend or revoke the registration of an NRSRO with respect to any type of securities if it finds that the NRSRO cannot consistently produce “credit ratings that are accurate.”
The SEC would be required to adopt a variety of other rules addressing NRSROs’ activities. NRSROs would be required to publicly disclose information on initial credit ratings for each type of obligor and security, in order to permit evaluation of rating accuracy and comparison of the performance of different NRSROs. SEC rules would require that ratings be adopted in accordance with approved internal methodologies; that material changes to those methodologies be consistently applied (including to existing ratings); and that end-users be notified of the methodologies used for each rating, whether a material change has been made to those methodologies and when any significant error is identified in those methodologies that may result in credit rating actions. Disclosure required to be provided with the publication of any credit rating generally would include the assumptions underlying rating methodologies, the data that was relied on in assigning a rating and the potential limitations on and uncertainty of the rating. Issuers and underwriters of ABS would be required to make public the findings of any third-party diligence report they obtain and any such report used by an NRSRO, an issuer or underwriter would be required to be certified to any NRSRO producing a related rating by the third-party service provider, and that certification would have to be publicly disclosed in connection with its rating.
The Act also would amend the Exchange Act to make it easier for aggrieved investors to sue NRSROs for damages by specifying less stringent pleading requirements for plaintiffs in securities fraud cases against NRSROs. In addition, NRSROs would be required by law to report to the appropriate regulator or law enforcement agency any information that the NRSRO “receives. . .and finds credible that alleges that an issuer of securities” rated by that NRSRO “has committed or is committing a material violation of law that has not been adjudicated by a Federal or State court.”
The proposed legislation also mandates a variety of studies of the regulation of rating agencies, though the deadlines for some of these studies have been pushed back somewhat from those that would have been required by the earlier draft Senate bill.
New to the Act from the prior draft is a provision that would make it clear that statements by rating agencies are subject to the same enforcement and penalty provisions as are statements made by registered public accounting firms and securities analysts, and that those statements do not have the benefit of the forward-looking statement safe harbor added by the National Securities Markets Improvements Act of 1996. In addition, the SEC would be required to adopt rules requiring NRSROs to adopt and enforce formal internal policies that assess the probability that issuers will default on their obligations, that clearly define and disclose the meanings of ratings symbols, and that apply ratings symbols consistently across various types of securities.
The provisions of the Act dealing with the ratings process continues to differ from the House bill in a variety of respects. Among other things, the House bill would create a Credit Ratings Agency Advisory Board to oversee the SEC’s regulation of NRSROs, would require the SEC to remove the exemption from Regulation FD for material nonpublic information provided to rating agencies and the rules designating an NRSROs rating a registered security as an “expert” subject to reduced liability, and would specifically permit the SEC to require issuers to disclose preliminary ratings of structured products and corporate debt.
The Act’s reduced risk retention requirements and its recognition of its potential negative impact on access to credit by consumers and businesses are encouraging, but the amount of discretion left with the Regulators likely would be troubling to securitizers and originators. However, the delay in the effectiveness of final implementing regulations until, at the earliest, 2012, would give the industry an opportunity to adjust to the new requirements or to petition Congress for relief. Whether the Senate can pass the Act, and if so how the differences between the Act and the House bill will be resolved, remain to be seen.
For assistance, please contact the following lawyers:
Reed D. Auerbach, Practice Group Leader, Structured Transactions
Edward E. Gainor, Partner, Structured Transactions
Steve Levitan, Partner, Structured Transactions
1Available at http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf.
2Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 111th Congress (2009).
3Bingham McCutchen LLP also expects to issue Legal Alerts on aspects of the Act other than those that apply specifically to ABS.
4The Act defines “securitizer” to mean ‘‘an issuer of an asset-backed security” or “a person who organizes and initiates an asset-backed securities transaction by selling or transferring assets, either directly or indirectly, including through an affiliate, to the issuer” (i.e., the “sponsor” within the meaning of Regulation AB).
5The Act defines “originator” to mean a person who sells an asset to a securitizer.
6The House bill uses the Regulation AB definition of “asset-backed security.”
7Section 15(d) of the Exchange Act provides that an issuer’s reporting obligation is suspended “as to any fiscal year, other than the fiscal year in which [the] registration statement became effective, if, at the beginning of such fiscal year, the securities of each class to which the registration statement relates are held of record by less than three hundred persons.” The Act would exclude asset-backed securities from this provision.